Social media engagement and the rise in low-fee online brokerage firms has increased accessibility to the stock market. In recent years, investors have taken to social media to share their investing strategies and make stock recommendations. While there is nothing inherently wrong in this, there is a smaller subset of advice where the line between helpful and illegal is crossed.
Recently, investors have taken to platforms such as Reddit to convince other investors to purchase shares of specific companies. Often, these companies are struggling or slowly growing obsolete and therefore have a low share price. By convincing others to purchase shares, they drive the prices to astronomical highs. The popularity of this investing strategy has been the subject of controversy as the Securities and Exchange Commission (SEC) - the United States’ financial regulatory body - continues to remain unclear on the legality of such actions. What the SEC needs to determine is whether or not this strategy falls under the umbrella of market manipulation.
The aforementioned stocks are known as meme stocks. These are stocks that have seen a large increase in trading activity brought on by viral threads on social media platforms. A sub-Reddit, “Wall Street Bets”, is most notable for these meme stocks. The movement started after investors on the platform criticised large financial firms for shorting struggling companies (to “short” a stock means to place bets that the stock price will decline) and sought to undermine this strategy by buying shares of the shorted company to artificially drive the price up. Examples of such stocks are GameStop and AMC Entertainment. Meme stocks have proven to be very costly for firms that take a short position on shares as they now have to pay to cover the losses incurred.
A meme stock has a specific life cycle that it follows, often moving through the phases quickly, which makes them a very risky proposition. First, a company is deemed undervalued, so investors begin purchasing shares. The stock then gains attention, so others begin to place buy orders. It goes viral through memes and investors who fear they are missing out purchase bulk orders, driving the price incredibly high. When buying looks like it is peaking, investors begin to sell their shares until the price crashes back down, leaving some people with major gains but most with major losses. The cycle then repeats itself. The company behind the meme stock generally does not equal the value of the shares at the peak buying period, so the price is artificially high and a crash is inevitable.
Within financial theory, there exists a concept called the efficient market hypothesis (EMH). What the EMH states is that the market is efficient enough to reflect new information immediately; it can keep up with every new trend. If there is a massive trend towards buying or selling a certain industry or stock, the market prices will reflect that. So, when there is a movement on Reddit to buy shares of AMC Entertainment en masse, the market price will increase to reflect the demand. To a novice investor on Reddit, this movement promises a get-rich-quick alternative to the traditional, long-term approach of most established institutions. What these burgeoning investors may not fully grasp is the higher these trendy stocks fly, the farther they can fall. It is, essentially, a trap for these new investors, and often the consequences are financially devastating.
The SEC has regulation surrounding the manipulation of financial markets for personal gain. The goal of manipulation is to deceive other investors into either buying or selling shares to misprice assets so they can reap a benefit. The difference between savvy investing or entrepreneurship and market manipulation is whether or not the strategy improves market efficiency and benefits society.
The meme stock movement is groupthink market manipulation as companies cannot match the value prescribed to it by the share price. These “advisors” are artificially inflating and deflating share prices of companies that are unable to match the value of the new price and are making an enormous profit at the expense of others. The astronomical rise and equally devastating fall indicates that there is no bottom price support (meaning that there is no limit to how far these stocks can plummet), leading to more novice investors incurring losses. Both brokerage firms and their clients and independent investors are negatively impacted by the trend, and thus it should fall under the regulations surrounding market manipulation.
As of now, the SEC has yet to make a statement regarding the legality of meme stocks. In fact, a review of their regulation surrounding market abuse and manipulation presents a vague definition of what it actually means. As the world, including finance and banking, moves online, there needs to be a clear definition of what constitutes illegal market activity. They need to clearly indicate whether or not this unsolicited financial advice through social media is an illicit activity with intent to manipulate.
If the SEC does not begin to crackdown on this behaviour, many more novice investors stand to lose money that otherwise could have been put towards better and safer investing strategies.